From his seat as chief investment officer at Mesirow Advanced Strategies, a $12.5 billion fund-of-hedge-funds manager based in Chicago, Stephen Vogt has a unique view of the still-unfolding crisis in the subprime mortgage sector. While analysts and economists argue about the magnitude of losses and risks associated with the collapse of the sector, Vogt and his fellow fund-of-funds managers are watching some of the market’s biggest winners and losers in something close to real time.
Hedge funds are among the biggest investors in collateralized debt obligations and other structured products that have helped drive the expansion of the mortgage market, including subprime loans. But as Vogt and other managers are quick to note, many hedge funds were shorting subprime lenders when the bottom fell out. For them, the current crisis has been a windfall.
“We had some indirect short exposure to the subprime market through many of our credit and event-driven managers,” Vogt says. “It provided nice protection.”
For many financial professionals, the ongoing collapse of the subprime mortgage market provides a perfect example of modern credit markets at work. During the past decade these markets have been transformed by innovative products that distribute risk among a wide pool of investors, who can select precisely the level of risk they are willing to bear. Hedge funds play a key role in this process as counterparties on credit-default swap contracts and investors in structured fixed-income products. If the process works as intended, every turn of the market should result in both winners and losers. With investors, including hedge funds, holding millions of divergent and opposing positions -- and the riskiest positions being held by those best equipped and most willing to manage them -- the next credit event should be, well, less of an event.
For now, at least, the subprime crisis seems to be keeping to that script. The troubles have yet to carry over into the broader mortgage market, and corporate credit spreads have been largely unaffected after an initial and brief widening. Ramesh Singh, head of debt capital markets in the Americas and global head of securitized products at financial powerhouse UBS, says he expects investors not previously involved in the subprime market to begin exploring the sector -- the typical reaction when opportunistic hedge funds and dealers’ proprietary trading desks get wind of a major repricing in an asset class. Just last month Goldman, Sachs & Co. CFO David Viniar indicated that his firm is looking at opportunities in the subprime market, and Barclays Bank recently completed the purchase of loan originator EquiFirst.
The fact that damage from the current crisis has not spread beyond subprime to any significant extent is taken by some as evidence of the resiliency that financial engineering has brought to global credit markets. But others remain skeptical that things are different this time and fear that credit spreads will widen eventually. Among the doubters is Leslie Rahl, a pioneer in the derivatives markets in the early 1980s and now president of Capital Market Risk Advisors, a New Yorkbased financial advisory firm devoted to risk management and hedge funds. Rahl testified as an expert witness in litigation related to the collapse of Askin Capital Management -- a hedge fund that was a primary buyer of risky mortgage securities before that market’s meltdown in 1994. “When push comes to shove, especially in times of stress,” she explains, “what someone is willing to pay for these things is not what the computer model says.”
The current subprime problems began in December 2006, with the failure of several mortgage originators, including Sebring Capital Partners, Ownit Mortgage Solutions, Harbourton Mortgage Investment Corp. and Mortgage Lenders Network. More failures followed in January. The crisis intensified on February 7, when HSBC Holdings announced that losses on its mortgage portfolio were far greater than expected, and loan originator New Century Financial disclosed that it would have to restate prior earnings. New Century and other originators had been selling to dealers loans to be packaged into securities, promising that they would buy the loans back if the borrowers defaulted too quickly. As default rates surged, it became apparent that the company hadn’t set aside enough cash to meet this burgeoning obligation. The news went from bad to worse when New Century, which was delisted by the New York Stock Exchange in February, declared bankruptcy earlier this month.
The downfall of New Century triggered major losses for at least one hedge fund, Greenlight Capital, whose manager, David Einhorn, lost money from exposure not to credit but to equity. The New Yorkbased activist hedge fund bought a stake in New Century in 2002, won a seat on the board after threatening a proxy fight last year and lost big when the subprime lender collapsed. In addition to loan originators and Greenlight, some of Wall Street’s biggest banks have taken hits. Major fixed-income dealers carry inventories of loans waiting to be packaged into securitized products. The value of some loans plummeted as defaults rose, and banks were unable to enforce their right to sell bad loans back to distressed originators at cost.
Despite these losses there has not yet been any sign that the market is in for a repeat of the 1994 crisis, in which mortgage-related losses at a single hedge fund -- Askin Capital -- essentially shut down the market and contributed to the collapse of Kidder, Peabody & Co.
Donald Fewer, senior managing director and head of North American brokerage at New Yorkbased GFI Group, a leading interdealer swaps and derivatives broker, notes that since 1994 credit markets have undergone a fundamental change: Credit risk, once concentrated among a small number of banks and investors, is today widely distributed. “We have developed credit-linked markets now that are able to absorb those shocks and the effect on credit spreads more than at any other time,” he says.
The main mechanisms for this risk distribution are the booming markets for credit default swaps and structured products. An International Swaps and Derivatives Association survey found that the notional value of outstanding credit default swaps doubled in the 12 months ended June 30, 2006, to more than $26 trillion. Credit derivatives began as relatively simple instruments: single-name credit default swaps that first allowed investors to hedge specific credit risk. Financial engineers next added the indexation of default risk, which enabled traders to exploit basis opportunities, or the yield spread of corporate credit over Treasuries. The final step in the development of today’s credit derivatives market was the introduction of structured credit pools sliced into narrow pieces, such as collateralized debt obligations and collateralized loan obligations. At every stage in this evolution, the market has gained liquidity by drawing in new participants -- especially hedge funds.
CDOs and CLOs repackage debt instruments into pools and divide the cash flows into securities, or tranches, that pay different coupons depending on the associated risk. The AAA-rated super senior tranche pays the lowest coupon because defaults would have to wipe out all the junior tranches before its investors suffered any loss. Junior tranches carry progressively higher coupons and lower ratings to compensate for the commensurate risk of credit losses. At the bottom of the mezzanine layer, ratings drop below investment grade; the equity tranche, which bears the first credit loss, is usually unrated but pays the highest coupon.
Hedge funds’ recent shorting of the subprime sector has been done through the ABX indexes. These products, which were launched in January 2006 and reference credit default swaps on a standardized basket of obligations drawn from the 20 biggest subprime home equity asset-backed securities issuers, are more liquid than single-name credit default swaps and exhibit greater price volatility. After HSBC announced that credit losses in its subprime mortgage portfolio were much worse than expected and New Century imploded, the BBB tranche of the ABX 06-2 index plunged from 90 in late January to a low of 63 a month later before bouncing back above 70. At the same time that many investors and loan originators were taking significant hits in subprime, hedge funds that had shorted the indexes were cashing in.
According to GFI’s Fewer, the development of the ABX indexes has changed the home equity loan market fundamentally. Before their rollout, liquidity in bonds backed by home equity loans, which are typically small private-label issues, would evaporate at the first signs of trouble.
“We now have an index market that survived very well the bankruptcy of the subprime lenders,” Fewer says. “The index has sold off, but people aren’t running for cover. It’s functioning, it’s liquid, and it’s growing.” He argues that index and structured products like CDOs and CLOs create a technical bid in the market that keeps liquidity flowing even in tough times.
From the perspective of the overall market, CDOs and CLOs create value by giving investors the ability to select whatever risk profile they want from among the various tranches. “Collateralized debt and loan products create efficiency,” says Mesirow’s Vogt. “You are able to price in a yield that is attractive to each of the various constituencies, so it’s a one-plus-one-equals-three situation.”
Of course, these efficiencies can be gained only if sellers can find investors for all the pieces at all risk levels. That’s where hedge funds come in. “Heretofore, where did you find an investor with the risk appetite to take the equity and the non-investment-grade tranches?” Vogt asks. “Hedge fund clients have a different risk profile, so now you have a vehicle through which the hard-to-place components of that structure have a natural investor.”
The efficiencies generated by the marriage of these new products to the universe of hedge fund investors have produced benefits extending well beyond the financial markets. Andy Chow, a portfolio manager at SCM Advisors, a San Franciscobased money manager with $12 billion in assets under management that specializes in fixed income, points out that CDOs of asset-backed securities fueled the spread of home ownership in the U.S. Chow has worked in the mortgage credit market since the late 1980s, when he started at Resolution Trust Corp., the government-sponsored entity that took on bad loans from the savings and loan crisis. He later joined Conseco Capital Management as a fixed-income portfolio manager and then ran mutual funds for ING Pilgrim Investments before joining SCM in 2002.
“A lot of social welfare has been created in allowing a significant number of U.S. residents who had not been able to buy homes to buy homes,” says Chow. “It really has opened up a huge opportunity for people.”
The fact that some of those opportunities have vanished over the past several months is a reminder that although new financial instruments do a good job of reallocating risk, they don’t eliminate it. “Spreads move with the default rate, and I don’t think any amount of financial engineering is going to eliminate that,” says Marty Fridson, CEO of FridsonVision, an independent research house that specializes in high-yield bonds.
Capital Market Risk Advisors’ Rahl suspects that many new players, including some hedge funds, underestimate how volatile over-the-counter instruments like credit derivatives can be when liquidity dries up. “I am quite confident that we are going to return to a more typical environment in which we are going to have wider spreads and higher volatility,” she says.
UBS’s Singh believes that the demand generated by the trading of new index and tranched products -- much of which comes from hedge funds -- will support the market through minor blips. But he notes that in a major dislocation like the one roiling the subprime mortgage market, all bets are off. Singh speaks from experience: He joined the mortgage-backed securities group at Kidder Peabody in 1989 and witnessed the 1994 debacle firsthand. When Kidder folded, Singh and his colleagues on the mortgage-backed securities team moved to PaineWebber and later formed the nucleus of a larger group at UBS.
“The market had no bid,” he says, referring to the early days of the subprime sell-off. “You see that in every market, whether it’s 1994 or 1998, or any market when you have everybody rushing for the door and there’s nobody on the other side.”
It appears that liquidity generated through trades of new financial products by investors like the hedge funds shorting the ABX indexes helped prevent that initial panic from spreading into the broader credit markets. But as veterans of past credit crises warn, it is still far too early to declare victory for the financial engineers.
